be required if the surrender value was not approximately equal to the amortised cost at each exercise date.
[IFRS 4.IG4 E2.12].
Insurance contracts (IFRS 4) 4311
The relief from applying IAS 39 or IFRS 9 to certain surrender options discussed above
does not apply to put options or cash surrender options embedded in an insurance
contract if the surrender value varies in response to the change in a financial variable
(such as an equity or commodity price or index) or a non-financial variable that is not
specific to a party to the contract. Furthermore, the requirement to separate and fair
value the embedded derivative also applies if the holder’s ability to exercise the put
option or cash surrender option is triggered by a change in such a variable, for example
a put option that can be exercised if a stock market index reaches a specified level.
[IFRS 4.8]. This is illustrated by the following example.
Example 51.23: Policyholder option to surrender contract for value based on a
market index
An insurance contract gives the policyholder the option to surrender the contract for a surrender value based
on an equity or commodity price or index.
The option is not closely related to the host insurance contract because the surrender value is derived from an
index and is not specific to a party to the contract. Therefore, measurement of the option at its fair value is
required. [IFRS 4.IG4 E2.14].
Embedded derivatives in insurance contracts are also required to be separated where
they do not relate to insurance risk and are not otherwise closely related to the host
contract. An example of this is illustrated below.
Example 51.24: Persistency bonus
An insurance contract gives policyholders a persistency bonus paid at maturity in cash (or as a period-
certain maturity).
The embedded derivative (the option to receive the persistency bonus) is not an insurance contract because,
as discussed at 3.7 above, insurance risk does not include lapse or persistency risk. Therefore, measurement
of the option at its fair value is required. [IFRS 4.IG4 E2.17].
If the persistency bonus was paid at maturity as an enhanced life-contingent annuity then the embedded
derivative would be an insurance contract and separate accounting would not be required. [IFRS 4.IG4 E2.18].
Non-guaranteed participating dividends contained in an insurance contract are discretionary
participation features rather than embedded derivatives and are discussed at 6 below.
Although IFRS 4 provides relief from the requirements of IAS 39 or IFRS 9 to separately
account for embedded derivatives, some derivatives embedded in insurance contracts
may still be required to be separated from the host instrument and accounted for at fair
value under IAS 39 or IFRS 9 as illustrated in Examples 51.23 and 51.24 above. In some
circumstances this can be a challenging and time consuming task.
4.1 Unit-linked
features
A unit-linked feature (i.e. a contractual term that requires payments denominated in
units of an internal or external investment fund) embedded in a host insurance contract
(or financial instrument) is considered to be closely related to the host contract if the
unit-denominated payments are measured at current unit values that reflect the fair
values of the assets of the fund. [IAS 39.AG33(g), IFRS 9.B4.3.8(g)].
IAS 39 or IFRS 9 also considers that unit-linked investment liabilities should be
normally regarded as puttable instruments that can be put back to the issuer at any time
for cash equal to a proportionate share of the net asset value of an entity, i.e. they are
4312 Chapter 51
not closely related. Nevertheless, the effect of separating an embedded derivative and
accounting for each component is to measure the combined instrument at the
redemption amount that is payable at the reporting date if the unit holders had exercised
their right to put the instrument back to the issuer. [IAS 39.AG32, IFRS 9.B4.3.7]. This seems
to somewhat contradict the fact that the unit-linked feature is regarded as closely
related (which means no separation of the feature is required) but the accounting
treatment is substantially the same.
5
UNBUNDLING OF DEPOSIT COMPONENTS
The definition of an insurance contract distinguishes insurance contracts within the
scope of IFRS 4 from investments and deposits within the scope of IAS 39 or IFRS 9.
However, most insurance contracts contain both an insurance component and a
‘deposit component’. [IFRS 4.10]. Indeed, virtually all insurance contracts have an implicit
or explicit deposit component, because the policyholder is generally required to pay
premiums before the period of the risk and therefore the time value of money is likely
to be one factor that insurers consider in pricing contracts. [IFRS 4.BC40].
A deposit component is ‘a contractual component that is not accounted for as a
derivative under IAS 39 or IFRS 9 and would be within the scope of IAS 39 or IFRS 9 if
it were a separate instrument’. [IFRS 4 Appendix A].
IFRS 4 requires an insurer to ‘unbundle’ those insurance and deposit components in
certain circumstances, [IFRS 4.10], i.e. to account for the components of a contract as if
they were separate contracts. [IFRS 4 Appendix A]. In other circumstances unbundling is
either allowed (but not required) or is prohibited.
Unbundling has the following accounting consequences:
(a) the insurance component is measured as an insurance contract under IFRS 4;
(b) the deposit component is measured under IAS 39 or IFRS 9 at either amortised
cost or fair value which may not be consistent with the measurement basis used
for the insurance component;
(c) premiums for the deposit component are not recognised as revenue, but rather as
changes in the deposit liability. Premiums for the insurance component are
typically recognised as revenue (see 3.8 above); and
(d) a portion of the transaction costs incurred at inception is allocated to the deposit
component if this allocation has a material effect. [IFRS 4.12, BC41].
The IASB’s main reason for making unbundling mandatory only in limited
circumstances was to give relief to insurers from having to make costly systems changes.
These changes have been needed to identify and separate the various deposit
components in certain contracts (e.g. surrender values in traditional life insurance
contracts) which may then have needed to be reversed when an entity applied what
became IFRS 17. However, the IASB generally regards unbundling as appropriate for all
large customised contracts, such as some financial reinsurance contracts, because a
failure to unbundle them might lead to the complete omission of material contractual
rights and obligations from the statement of financial position. [IFRS 4.BC44-46].
Insurance contracts (IFRS 4) 4313
5.1
The unbundling requirements
Unbundling is required only if both the following conditions are met:
(a) the insurer can measure the deposit component (including any embedded
surrender options) separately (i.e. without considering the insurance component);
and
(b) the insurer’s accounting policies do not otherwise require it to recognise all
Unbundling is permitted, but not required, if the insurer can measure the deposit
component separately as in (a) but its accounting policies require it to recognise all
obligations and rights arising from the deposit component. This is regardless of the basis
used to measure those rights and obligations. [IFRS 4.10(b)].
Unbundling is prohibited when an insurer cannot measure the deposit component
separately. [IFRS 4.10(c)].
Example 51.25: Unbundling
A cedant receives compensation for losses from a reinsurer but the contract obliges the cedant to repay the
compensation in future years. That obligation arises from a deposit component.
If the cedant’s accounting policies would otherwise permit it to recognise the compensation as income without
recognising the resulting obligation, unbundling is required. [IFRS 4.11].
5.2 Unbundling
illustration
The implementation guidance accompanying IFRS 4 provides an illustration of the
unbundling of the deposit component of a reinsurance contract which is reproduced in
full below.
Example 51.26: Unbundling a deposit component of a reinsurance contract
Background
A reinsurance contract has the following features:
(a) the cedant pays premiums of CU10 every year for five years;
(b) an ‘experience account’ is established equal to 90% of the cumulative premiums (including the
additional premiums discussed in (c) below) less 90% of the cumulative claims;
(c) if the balance in the experience account is negative (i.e. cumulative claims exceed cumulative
premiums), the cedant pays an additional premium equal to the experience account balance divided by
the number of years left to run on the contract;
(d) at the end of the contract, if the experience account balance is positive (i.e. cumulative premiums exceed
cumulative claims), it is refunded to the cedant; if the balance is negative, the cedant pays the balance to
the reinsurer as an additional premium;
(e) neither party can cancel the contract before maturity; and
(f) the maximum loss that the reinsurer is required to pay in any period is CU200.
The contract is an insurance contract because it transfers significant risk to the reinsurer. For example, in case
2 discussed below, the reinsurer is required to pay additional benefits with a present value, in year 1, of CU35,
which is clearly significant in relation to the contract.
4314 Chapter 51
The following discussion addresses the accounting by the reinsurer. Similar principles apply to the accounting
by the cedant.
Application of requirements: case 1 – no claims
If there are no claims, the cedant will receive CU45 in year 5 (90% of the cumulative premiums of CU50). In
substance, the cedant has made a loan, which the reinsurer will repay in one instalment of CU45 in year 5.
If the reinsurer’s accounting policies require it to recognise its contractual liability to repay the loan to the
cedant, unbundling is permitted but not required. However, if the reinsurer’s accounting policies would not
require it to recognise the liability to repay the loan, the reinsurer is required to unbundle the contract.
If the reinsurer is required, or elects, to unbundle the contract, it does so as follows. Each payment by
the cedant has two components: a loan advance (deposit component) and a payment for insurance
cover (insurance component). Applying IAS 39 or IFRS 9 to the deposit component, the reinsurer is
required to measure it initially at fair value. Fair value could be determined by discounting the future
cash flows from the deposit component. Assume that an appropriate discount rate is 10% and that the
insurance cover is equal in each year, so that the payment for insurance cover is the same in each year.
Each payment of CU10 by the cedant is then made up of a loan advance of CU6.7 and an insurance
premium of CU3.3.
The reinsurer accounts for the insurance component in the same way it accounts for a separate insurance
contract with an annual premium of CU3.3.
The movements in the loan are shown below.
Year
Opening balance
Interest at 10% Advance
Closing balance
(repayment)
CU CU CU CU
0 0.00
0.00
6.70
6.70
1 6.70
0.67
6.70
14.07
2 14.07
1.41
6.70
22.18
3 22.18
2.21
6.70
31.09
4 31.09
3.11
6.70
40.90
5 40.90
4.10
(45.00)
0.00
Total
11.50
(11.50)
Application of requirements: case 2 – claim of CU150 in year 1
Consider now what happens if the reinsurer pays a claim of CU150 in year 1. The changes in the experience
account, and the resulting additional premiums, are as follows:
Year Premium Additional
Total Cumulative Claims Cumulative Cumulative Experience
premium premium
premium
claims
premiums
account
less claims
CU
CU
CU
CU
CU
CU
CU
CU
0 10 0
10
10
0
0
10 9
1 10 0
10
20
(150)
(150)
(130)
(117)
2 10 39
49
69
0
(150)
(81)
(73)
3 10 36
46
115
0
(150)
(35)
(31)
4 10 31
41
156
0
(150)
6 6
Total
106
156
(150)
Insurance contracts (IFRS 4) 4315
Incremental cash flows because of the claim in year 1
The claim in year 1 leads to the following incremental cash flows, compared with case 1:
Year
Additional
Claims Refund
in Refund in
Net
Present
premium
case 2
case 1
incremental
value
cash flow
at 10%
CU CU
CU
CU
CU CU
0
0 0
0 0
1 0
(150)
(150)
(150)
2 39
0
39
35
3 36
0
36
30
4 31
0
31
23
5 0
0
(6)
(45)
39
27
Total 106 (150)
(6)
(45)
(5) (35)
The incre
mental cash flows have a present value, in year 1, of CU35 (assuming a discount rate of 10% is
appropriate). Applying paragraphs 10-12 of IFRS 4, the cedant unbundles the contract and applies IAS 39 or
IFRS 9 to this deposit component (unless the cedant already recognises its contractual obligation to repay the
deposit component to the reinsurer). If this were not done, the cedant might recognise the CU150 received in
year 1 as income and the incremental payments in years 2-5 as expenses. However, in substance, the reinsurer
has paid a claim of CU35 and made a loan of CU115 (CU150 less CU35) that will be repaid in instalments.
The following table shows the changes in the loan balance. The table assumes that the original loan shown in case 1
and the new loan shown in case 2 meet the criteria for offsetting in IAS 32. Amounts shown in the table are rounded.
Year Opening
Interest
Payments per
Additional
Closing
balance
at 10%
original schedule
payments in case 2
balance
CU
CU
CU
CU
CU
0 –
–
6
–
6
1 6
1
7
(115)
(101)
2 (101)
(10)
7
39
(65)
3 (65)
(7)
7
36
(29)
4 (29)
(3)
6
31
5
5 5
1
(45)
39
0
Total
(18)
(12)
30
Although the example refers to ‘in year’ the calculations indicate that most of the cash flows occur at the end
of each year. The present value table showing the incremental cash flows resulting from the claim ‘in year 1’
appear to show the present values at the end of year 1. [IFRS 4.IG5 E3].
5.3 Practical
difficulties
In unbundling a contract the principal difficulty is identifying the initial fair value of any
deposit component. In the IASB’s illustration at 5.2 above a discount rate is provided
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 854
